Saturday, June 18, 2011

Something very peculiar is afoot. Well after the bank regulatory reform debate was supposedly settled, central bankers seem to be reopening that discussion. It’s puzzling because the very reason the banks won so decisively was that central bankers were not prepared to get all that tough with their charges.

I’m not clear what has led central bankers to get a bit of religion. Is it the spectacle of the Bank of England talking about breaking up the banks (they won’t get their way thanks to bank lobbyist working over the Independent Banking Commission, but no one doubted their sincerity)? Or the Swiss National Bank imposing 19% capital requirements, which as we discussed, is likely to lead to the investment banking are of UBS being domiciled elsewhere (assuming a country capable of bailing it out will have it)? Or perhaps it is central bankers being forced to recognize that their Plan A of extend and pretend and super low interest rates simply won’t lead banks getting to meaningfully higher capital levels when the staff continues to take egregious amounts out in compensation? Or have they realized how bad bank balance sheets are in the Eurozone and how tight the linkages still are among the major capital markets players, and they belatedly realize they need them to be much more shock resistant?

The bottom line is that various central bankers have taken the surprising step of insisting their banks meet more stringent requirements for the biggest banks than those originally planned to be to be included in Basel III.

Basically, the point is that some countries' regulators are considering implementing stricter regulations than those agreed in the multilateral Basel accords. How "peculiar" is this? Not very. The above heat map* shows capital-to-asset requirements for about 140 countries in 2006. The data come from this World Bank survey, which was the third of its kind. The darker the color, the higher the minimum ratio required by governments. (White countries are missing data, which means non-respondents to the survey.) At the time, the Basel requirements were 8% capital, of which 4% needed to be equity capital, represented by the beige color of the United States. The interesting thing about this is the number of countries that had tighter restrictions than those minima. It's nearly half of the sample**.

This might surprise some, who believe that absent a tough international standard national governments will "race to the bottom" in order to give their firms a competitive edge. But that doesn't tend to happen. Nor does it happen much in the private sector. Banks routinely over-comply with capital requirements, as doing so signals to investors that they are safe firms, which in turn lowers their borrowing costs. Pre-crisis almost all of the major banks had capital ratios that were not only well above the Basel II requirements, but also above the proposed Basel III requirements as well***. Rather than push up against the regulatory capital minimum, banks tried to signal credibility by maintaining capital ratios that were often twice as large as legally required. In some cases, banks lobbied their governments for stricter regulations, especially if those could also be applied to their foreign competitors or otherwise shield them from competition. Note that the countries with darker colors above, i.e. those with stricter regulations, are most often middle income countries most in need of signaling credibility.

Obviously this over-compliance didn't do much good in 2008, but that doesn't mean it wasn't happening.

I presented some preliminary research on this at this year's International Studies Association meeting. It's not yet in suitable shape for me to post the paper, or to report any firm conclusions, but one thing I think is fairly clear: popular commentators, and most academics, have been thinking about the relationship between firms' and governments' preferences over regulatory policies in some pretty wrong ways. It isn't just a race to the bottom. There's more going on.

**43%, if I remember correctly. And that doesn't include other "pseudo-regulations", like the US' requirement of 10% capital to be considered "well-capitalized" by the FDIC, that operated as de facto requirements.

***At least in terms of capital; leverage and liquidity is another thing entirely.